66 Pages Posted: 9 Oct 2017
Date Written: October 5, 2017
Law and economics scholars have long argued that efficiency is best served when a firm’s capital structure is arranged as a hierarchical value waterfall: the senior-most investors are made whole before the next-junior stakeholders receive anything. The mechanism chosen to implement this single waterfall approach—a blanket lien on all of a firm’s assets—is property-based. Senior investors are deemed to “own” a priority claim to the value of the firm. Since the comprehensive revision to Article 9 of the Uniform Commercial Code in 2000 lawyers, scholars, and judges have largely accepted at face value the assumption that a secured lender can write contracts that enable it to capture all of a distressed company’s going-concern value. Lynn LoPucki, Elizabeth Warren, Lucian Bebchuk and Jesse Fried—and, before them, Grant Gilmore—questioned the wisdom of this view. In this article, we join and amplify the views of these skeptics as a normative matter, but more importantly, we question the assumption the single waterfall has been achieved. We show that, as a positive matter, both Article 9 and the Bankruptcy Code retain the distinction between (1) lien-based priority over specific assets and their identifiable proceeds, and (2) unsecured claims against the residual value of the firm. We then explore the implications and reasons for taking such an approach.
Our positive account explicates how the term “equity” is used in both Chapter 11 of the Bankruptcy Code and Article 9 of the UCC to implement the principle of equality of treatment over time. “Equity,” as that term is used in the two statutes, reflects a core principle of collateral tracing that manages questions of value allocation over the course of a Chapter 11 case that we call “Equitable Realization.” While the term is ours, we derive it from the statutory terms “equitable principles” in Article 9 and “the equities of the case” in Chapter 11. Both refer to equitable tracing principles, that, in turn, inform the “fair and equitable baseline entitlement for secured creditors in a Chapter 11 plan.
We show that Chapter 11 treats realization of value as a two-step process—first, fixing the relative positions of secured and unsecured claims when a bankruptcy petition is filed, and second, delaying the fixing of the value of secured claims until collateral is sold or a Chapter 11 plan is confirmed. Equitable Realization uses tracing principles to allocate a firm’s value between asset-based and firm-based claimants and to preserve that allocation over time. Assets may appreciate, but once they are disposed of, their value is fixed. As a result, increases in going-concern value, and other bankruptcy-created value are not identifiable proceeds traceable to a lender’s pre-bankruptcy collateral. The secured creditor’s entitlement to any bankruptcy-created value extends only to “identifiable proceeds”—value that can be traced to assets encumbered on the petition date.
Our positive analysis, of course, raises the question of whether Article 9 and the Bankruptcy Code get it right. We explain not only why Equitable Realization is normatively superior to the single waterfall approach, but how it is baked into corporate and commercial law more generally, and is part of a large family of rules that guard against undercapitalization and judgment proofing. Indeed, these rules are implemented through property as well as liability rules. Thus, Equitable Realization not only implements the Bankruptcy Code’s core goal of equitable treatment of creditors, but, by properly identifying firms’ residual claimants, limits a firm’s ability to externalize risk and increases the prospect of reorganizing troubled companies. Our analysis reveals the infirmities of recent value-allocation proposals in the academic literature as well as in the Final Report of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11.
Keywords: bankruptcy, equity, tracing, law and economics, commercial law, secured credit, corporate finance
Suggested Citation: Suggested Citation
Janger, Edward J. and Jacoby, Melissa B., Tracing Equity: Realizing and Allocating Value in Chapter 11 (October 5, 2017). Texas Law Review, Forthcoming; UNC Legal Studies Research Paper. Available at SSRN: https://ssrn.com/abstract=3048336